True Economic Substance. Concept. Definition. Criteria

The doctrine of substance (or rather substance over form) was introduced into US tax law to distinguish between transactions whose sole purpose is to reduce tax burden and transactions that have real economic benefit (substance).

However in the recent years, being predetermined 1) by the new legislation in a number of offshore territories (BVI, Bermuda, Cayman, Isle of Man, Jersey, Guernsey, etc.) and 2) by banks (mainly Cyprus and Baltic ones) that open accounts for offshore companies, substance has come to mean Economic Substance (effectively physical presence).

It seems logical to us to divide the term Economic Substance into two sub-terms:

It is a combination of factors ensuring (guaranteeing, proving) that the company is an actual resident of a particular country. These factors include:

• Real office. Having one is confirmed by a) lease agreement, b) bank statements reflecting regular rent payments, c) Office Utility Bill – utility bills issued to a legal entity.
• Employees (preferably local). Having these is characterized by а) employment contracts, b) bank statements reflecting regular salary payments, c) justified staff schedule and specific positions in it, d) salary adequate to the position, e) appropriate professional qualification of the employee, e) justified hiring of a foreign (rather than local) employee, g) contributions to a pension fund, payment of insurance and personal taxes.
• Landline and mobile phone, website with a national domain, a local server, mobile utility bill.
• Local bank account (at least one). The account should be operated from local IP addresses. Signatory to the account is a local employee.
• Appropriate corporate structure ensuring that decisions are made and executive body and/or controlling persons are located in the company's jurisdiction of incorporation.
• Tax residence. Supporting documents are: a) certificate of tax residence in the current tax period containing a tax number, b) tax reporting documents, forms, tax returns, c) documents (cheques, pay slips, receipts) confirming payment of taxes.
• Keeping essential documentation and corporate ‘gear’ in the office. This includes: а) financial statements, accounting and business records, bank statements, business contracts; b) corporate documents, resolutions and minutes; c) seals and stamps; d) electronic media containing day-to-day correspondence and commercial documentation; e) safe, petty cash, tokens and access keys to bank accounts.
• Means of production (equipment), office space, computer stations, advertising booklets, samples, materials, booklets, warehouse equipment, stocks of products.

This list of criteria for true substance is exhaustive. It is usually sufficient to provide evidence of compliance with 50-75% of the above. But if you prefer to take a thorough approach, leaving nothing to chance, then the recommendation is to comply with all the criteria.

A formal economic substance is usually required to comply with a bank’s request to provide evidence that a company has economic substance in its country of incorporation. A bank would normally be satisfied if the following is in place:

• Office lease agreement (sub-lease agreement). May want to see evidence of regular payments under the lease agreement.
• Employment agreements with employees. May want to see evidence of regular payments under employment agreements.
• Contact phone numbers. May make a test call to check, in which case a call forwarding service can be useful.
• further requirements depend on the bank’s policy, whether the bank is ready to treat its obligation to monitor economic substance as a formality.

Curiously enough, it is currently problematic to exactly define “Economic Substance” because the legislators in offshore jurisdictions have not yet fully formulated the entire set of criteria determining this economic concept, and are likely to cross swords as to whether or not a particular company has economic substance in the given territory. The numerous Guidelines (circulars and clarifications) already published and still awaited by the industry and the Economic Substance Code will all aim to define the Economic Substance.

GSL offers packages for setting up of true economic substance (to comply with statutory requirements, for example, in the BVI) or packages of formal (virtual) economic substance (to comply with requirements of banks and EMIs):

BVI. True Economic Substance

• office lease agreement in the country of incorporation
• employment agreement with a local employee
• phone number with call forwarding
• local bank account (First Bank, Bank of Asia, VP Bank (BVI) Limited)
• other criteria upon request

BVI. Formal (Virtual) Economic Substance

• office lease agreement in the country of incorporation
• employment agreement with a local employee